As comfortable as we are in our 1955 Ford Fairlane, we all need to get ready for some changes. CFOs everywhere that use GAAP will need to get out of their comfort zones and pay attention to painful changes coming in how the Financial Accounting Standards Board (“FASB”) treats commercial property leases.
FASB’s new rules will dramatically affect balance sheets and profit and loss statements for businesses, professional firms and even non-profits that use GAAP (Generally Accepted Accounting Principles). The changes are being enacted worldwide to provide more transparent financial reporting by firms that have multi-year leases for commercial property.
WHY DID FASB DO THIS?
The motivation for FASB’s Rule changes dates back 15 years to giant corporate implosions by Enron and WorldCom, both of which were precipitated by hidden, off-balance sheet liabilities. And when they came to light, the roof caved in.
Here’s an overview of entities that will be affected by FASB Rule changes and when:
- They will affect public, private and non-profit companies that use GAAP.
- Public companies will start using new FASB Standards in 2019.
- Private companies will follow in 2020.
- Two-year look-back records will be required, so companies must begin accounting for changes in 2017 and 2018.
WHAT’S UNDER THE HOOD OF FASB’S NEW RULES?
Currently, most leases for office and industrial space are classified as “operating leases” and the impact to a company’s financial statements generally pertains only to its current year profit and loss statements (“P&Ls”). A lease expense is typically shown for the current calendar or fiscal year, but the liability for the lease in subsequent years is not noted on the balance sheet.
New FASB requirements will, instead, require a company to record its multi-year operating lease(s) on its balance sheet as a liability for the full lease term, not just for the current year. FASB is doing this to provide acknowledgement that future lease payment obligations exist.
This is a Big Deal and it means painfully saying good-bye to off-balance sheet liabilities. Balance sheets will be growing for most companies.
Future lease payments for multi-year leases will be recorded as liabilities on balance sheets and corresponding “Rights of Use” will be entered as assets. However, these entries won’t necessarily be equal. Companies will experience higher levels of liabilities as compared to assets at the commencement of their lease terms. This will negatively alter commonly used financial ratios. This will be especially important for firms with capital reserve requirements, such as insurance firms, banks and other financial institutions.
Other than recording multi-year leases and their full lease term value on balance sheets, what else is contained in FASB’s new regulations?
NOT-SO-WELCOME FEATURE OF NEW VEHICLE
Businesses will also have to record values on their balance sheets for all future options to renew.
Yes, while some subjectivity may occur, it’s likely that values for most renewal options will have to be recorded on companies’ balance sheets.
As a result, if your firm has a new 10-year lease, with a 5-year option to renew, you will likely be forced to record a 15-year lease liability on your balance sheet.
These new FASB Rules could get pretty ugly pretty fast.
HOW NEW FASB RULES WILL AFFECT COMPANIES
We believe multiple issues will occur:
- Company borrowing capacities may be reduced.
- Capital reserve (idle cash) requirements could be increased, almost certainly affecting insurance firms, banks and financial institutions.
- Fortunately, most lease liabilities won’t be classified as debt, so this won’t hurt debt ratios, except for businesses using IFRS (more on this below).
- At the transition point to new FASB Rules, companies will have balance sheet liabilities that are greater than their corresponding assets. Over time, though, this will reverse itself as leases burn down closer to expiration dates.
- However, since companies renew their leases about 70% of the time, this future benefit, where asset values will be greater than liability values, in most cases will never be fully realized. That’s because most leases are extended before they actually expire or new spaces are leased elsewhere prior to expiration of current leases.
- International companies that report under International Financial Reporting Standards (“IFRS”) must record all leases as “finance leases,” which, in the effective year, will create even larger differences on their balance sheets and P&Ls. This will be the result of lease entries for current year expenses also including interest and amortization expenses that are front-loaded on leases.
While each company’s exposure will be different, this could represent a 10% to 20% increase (or more) in lease expenses reflected in the first year of FASB Rules implementation.
IFRS companies will also need to assess the new rules’ repercussions on finance leases because their liabilities on balance sheets, unfortunately, will be classified as debt and that will negatively affect their debt ratios.
If your company or professional firm uses GAAP and has a lease expiring or new space requirements in the next few years, it’s critical for you, your CFO and CPA to understand how these FASB accounting changes will transform your financial statements, earnings, taxes and valuation.
By planning ahead for your business and family and negotiating leases that take these new elements into consideration, you will have opportunities to reduce the impact of FASB Rule changes on your financial statements. Nevertheless, it’s important to review your situation soon.
Furthermore, we believe that the new FASB Rules may cause some small to mid-sized, privately held companies and professional firms, primarily those located in suburban areas, to seriously consider buying or constructing their own buildings (and paying rent to themselves). Using an SBA 504 Loan may make this a very viable and palatable option for some Tenants, which we discuss in our blog article, How to win with SBA Loan and rent from yourself.
* Note: Portions reprinted with permission of Wayne Teig and ITRA Global, based on Canonical Reference to ITRA Global’s press release, dated January 11, 2017, For Some CFOs, New FASB Lease Accounting Rules a Bang – For Others a Whimper.